Download Session 14 - Investment Returns I

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Show me the money
Set Up and Objective
1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate
4. Define & Measure Risk
5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights
The Financing Decision
Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations
Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing
Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends
36. Closing Thoughts
The Dividend Decision
If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business
Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation
First Principles
Maximize the value of the business (firm)
The Investment Decision
Invest in assets that earn a
return greater than the
minimum acceptable hurdle
The hurdle rate
should reflect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.
The return should
reflect the
magnitude and
the timing of the
cashflows as welll
as all side effects.
The Financing Decision
Find the right kind of debt
for your firm and the right
mix of debt and equity to
fund your operations
The optimal
mix of debt
and equity
maximizes firm
The right kind
of debt
matches the
tenor of your
The Dividend Decision
If you cannot find investments
that make your minimum
acceptable rate, return the cash
to owners of your business
How much
cash you can
depends upon
current &
How you choose
to return cash to
the owners will
depend on
whether they
prefer dividends
or buybacks
Measures of return: earnings versus cash flows
Principles Governing Accounting Earnings Measurement
Accrual Accounting: Show revenues when products and services are sold or provided, not
when they are paid for. Show expenses associated with these revenues rather than cash
Operating versus Capital Expenditures: Only expenses associated with creating revenues in the
current period should be treated as operating expenses. Expenses that create benefits over
several periods are written off over multiple periods (as depreciation or amortization)
To get from accounting earnings to cash flows:
you have to add back non-cash expenses (like depreciation)
you have to subtract out cash outflows which are not expensed (such as capital expenditures)
you have to make accrual revenues and expenses into cash revenues and expenses (by
considering changes in working capital).
Measuring Returns Right: The Basic Principles
Use cash flows rather than earnings. You cannot spend
 Use “incremental” cash flows relating to the investment
decision, i.e., cashflows that occur as a consequence of
the decision, rather than total cash flows.
 Use “time weighted” returns, i.e., value cash flows that
occur earlier more than cash flows that occur later.
The Return Mantra: “Time-weighted, Incremental Cash
Flow Return”
Earnings versus Cash Flows: A Disney Theme
The theme parks to be built near Rio, modeled on Euro
Disney in Paris and Disney World in Orlando.
The complex will include a “Magic Kingdom” to be
constructed, beginning immediately, and becoming
operational at the beginning of the second year, and a second
theme park modeled on Epcot Center at Orlando to be
constructed in the second and third year and becoming
operational at the beginning of the fourth year.
The earnings and cash flows are estimated in nominal U.S.
Key Assumptions on Start Up and Construction
Disney has already spent $0.5 Billion researching the proposal and getting
the necessary licenses for the park; none of this investment can be
recovered if the park is not built. This expenditure has been capitalized
and will be depreciated straight line over ten years to a salvage value of
Disney will face substantial construction costs, if it chooses to build the
theme parks.
The cost of constructing Magic Kingdom will be $3 billion, with $ 2 billion to be
spent right now, and $1 Billion to be spent one year from now.
The cost of constructing Epcot II will be $ 1.5 billion, with $ 1 billion to be spent at
the end of the second year and $0.5 billion at the end of the third year.
These investments will be depreciated based upon a depreciation schedule in the
tax code, where depreciation will be different each year.
Step 1: Estimate Accounting Earnings on Project
Direct expenses: 60% of revenues for theme parks, 75% of revenues for resort properties
Allocated G&A: Company G&A allocated to project, based on projected revenues. Two
thirds of expense is fixed, rest is variable.
Taxes: Based on marginal tax rate of 36.1%
And the Accounting View of Return
Based upon book capital at the start of each year
Based upon average book capital over the year
What should this return be compared to?
The computed return on capital on this investment is about 4%. To
make a judgment on whether this is a sufficient return, we need to
compare this return to a “hurdle rate”. Which of the following is
the right hurdle rate? Why or why not?
The riskfree rate of 2.75% (T. Bond rate)
The cost of equity for Disney as a company (8.52%)
The cost of equity for Disney theme parks (7.09%)
The cost of capital for Disney as a company (7.81%)
The cost of capital for Disney theme parks (6.61%)
None of the above
Should there be a risk premium for foreign
The exchange rate risk should be diversifiable risk (and hence should not
command a premium) if
the company has projects is a large number of countries (or)
the investors in the company are globally diversified.
For Disney, this risk should not affect the cost of capital used. Consequently, we would not
adjust the cost of capital for Disney’s investments in other mature markets (Germany, UK,
The same diversification argument can also be applied against some political risk,
which would mean that it too should not affect the discount rate. However, there
are aspects of political risk especially in emerging markets that will be difficult to
diversify and may affect the cash flows, by reducing the expected life or cash flows
on the project.
For Disney, this is the risk that we are incorporating into the cost of capital when it
invests in Brazil (or any other emerging market)
Estimating a hurdle rate for Rio Disney
We did estimate a cost of capital of 6.61% for the Disney theme park business, using a bottom-up
levered beta of 0.7537 for the business.
This cost of equity may not adequately reflect the additional risk associated with the theme park
being in an emerging market.
The only concern we would have with using this cost of equity for this project is that it may not
adequately reflect the additional risk associated with the theme park being in an emerging market
(Brazil). We first computed the Brazil country risk premium (by multiplying the default spread for
Brazil by the relative equity market volatility) and then re-estimated the cost of equity:
Country risk premium for Brazil = 5.5%+ 3% = 8.5%
Cost of Equity in US$= 2.75% + 0.7537 (8.5%) = 9.16%
Using this estimate of the cost of equity, Disney’s theme park debt ratio of 10.24% and its aftertax cost of debt of 2.40% (see chapter 4), we can estimate the cost of capital for the project:
Cost of Capital in US$ = 9.16% (0.8976) + 2.40% (0.1024) = 8.46%
Would lead us to conclude that...
Do not invest in this park. The return on capital of 4.18% is
lower than the cost of capital for theme parks of 8.46%; This
would suggest that the project should not be taken.
Given that we have computed the average over an arbitrary
period of 10 years, while the theme park itself would have a
life greater than 10 years, would you feel comfortable with
this conclusion?
A Tangent: From New to Existing Investments:
ROC for the entire firm
How “good” are the
existing investments
of the firm?
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
capital) assets
Expected Value that will be
created by future investments
Assets in Place
Growth Assets
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
Measuring ROC for existing investments..
Old wine in a new bottle.. Another way of
presenting the same results…
The key to value is earning excess returns. Over time, there have been
attempts to restate this obvious fact in new and different ways. For
instance, Economic Value Added (EVA) developed a wide following in the
the 1990s:
EVA = (ROC – Cost of Capital ) (Book Value of Capital Invested)
The excess returns for the four firms can be restated as follows:
6 Application Test: Assessing Investment Quality
For the most recent period for which you have data, compute the
after-tax return on capital earned by your firm, where after-tax
return on capital is computed to be
After-tax ROC = EBIT (1-tax rate)/ (BV of debt + BV of EquityCash)previous year
For the most recent period for which you have data, compute the
return spread earned by your firm:
Return Spread = After-tax ROC - Cost of Capital
For the most recent period, compute the EVA earned by your firm
EVA = Return Spread * ((BV of debt + BV of Equity-Cash)previous year
Estimate the
earned by
your company
Chapter 5,6